Johnson and Kwak vs. Bernanke

Simon Johnson and James Kwak of the Baseline Scenario argue in today’s Washington Post that the Fed risks triggering an inflationary spiral despite the current gaping output gap (see also Mark Thoma’s comments here). I believe that Johnson and Kwak are perpetuating a misunderstanding about Federal Reserve Chairman Ben Bernanke’s policy intentions, namely boosting inflation expectations. This is an understandable extension of the widely cited policy of quantitative easing. But despite the widespread use of the term quantitative easing, I still believe this is not Bernanke’s understanding of the Fed’s policy stance (see also David Altig). And, I would argue, if this is indeed the Fed’s policy, Bernanke is doing a very bad job at implementation.The key paragraph in Johnson and Kwak that I take issue with is:

Then in March, the Fed said that it will begin buying long-term Treasury bonds on the open market, hoping to push down long-term interest rates (by increasing the amount of money available for long-term lending) and thereby stimulate borrowing. The implication is that the Fed will finance these purchases by creating money. Not only that, but Bernanke wants us to know exactly what the Fed is doing; he hopes to push up our expectations of future inflation, so that wages and prices will nudge upwards, not downwards.

The implicit assumption is that the Fed is expanding the money supply via a policy of quantitative easing with the explicit goal of raising inflation expectations. First off, as Bernanke said once again today, he does not describe policy as quantitative easing:

In pursuing our strategy, which I have called “credit easing,” we have also taken care to design our programs so that they can be unwound as markets and the economy revive. In particular, these activities must not constrain the exercise of monetary policy as needed to meet our congressional mandate to foster maximum sustainable employment and stable prices.

Pay close attention to Bernanke’s insistence that the Fed’s liquidity programs are intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment – a commitment to contract the money supply in the future. Is this any way to boost inflation expectations? See also Paul Krugman:

In that case monetary policy can’t get you there: once the interest rate hits zero, people will just hoard any additional cash – we’re in the liquidity trap. The only way to make monetary policy effective once you’re in such a trap, at least in this framework, is to credibly commit to raising future as well as current money supplies.

If Bernanke really intends to raise inflation expectations, he is making an elementary error by reiterating his intention to shrink the Fed’s balance sheet in the future. The current increase in money supply is thus transitory and should not affect future expectations of inflation. I can’t see him making such an elementary error, which suggests that Bernanke’s word should be taken at face value; he intends policy to be “credit easing,” not the oft-cited “quantitative easing.”

To be sure, the Fed is setting the stage for inflation if the price for their efforts to stabilize the financial system is monetary independence. The Fed is very, very aware of this risk; expect policymakers to keep reiterating Bernanke’s intention to maintain independence. Note that he made this point in the quote above, and makes it again later in the same speech:

The FOMC will continue to closely monitor the level and projected expansion of bank reserves to ensure that–as noted in the joint Federal Reserve-Treasury statement–the Fed’s efforts to improve the workings of credit markets do not interfere with the independent conduct of monetary policy in the pursuit of its dual mandate of ensuring maximum employment and price stability. As was also noted in the joint statement, to provide additional assurance on this score, the Federal Reserve and the Treasury have agreed to seek legislation to provide additional tools for managing bank reserves.

Johnson and Kwak also attempt to deal with the central criticism of inflation worries: How can inflation emerge given the gaping output gap? They solve this puzzle by analogizing the US to an emerging economy:

But is the United States really a normal advanced economy anymore? We seem to have taken on some features of so-called emerging markets, including a bloated (and contracting) financial sector, overly indebted consumers, and firms that are trying hard to save cash by investing less. In emerging markets there is no meaningful idea of “slack;” there can be high inflation even when the economy is contracting or when growth is considerably lower than in the recent past.

The challenge in my mind is that institutions in the US, primarily the relationship between management and labor, are not conducive to sustained inflation as they are in emerging markets. Desperation among workers is more likely to take hold. From today’s Wall Street Journal:

Despite what objectives they may have put atop their resumes, when asked to describe the work they really wanted, the job seekers largely had the same goal: “I’ll take anything right now.”

In many cases, that desperation means that even educated workers must trade down to jobs below their potential and with lower pay. That results in painful, long-term effects, from hurting their own career advancement to displacing those with less education or experience.

Frankly ,I don’t see a clear transition mechanism within the US economy to generate sustained inflation in this environment. I am somewhat more sympathetic to another threat Simon and Kwak identify:

We do not want to become more like Argentina in 2001-2002 or Russia in 1998, when currencies collapsed and inflation soared.

If the US Dollar cracked – a frequent fear of mine during the past year – and commodity prices surge, and the Fed effectively accommodated that price increase by easing policy further to counter the negative demand effect, which would effectively be a permanent increase in the money supply, then I can tell a story about an inflationary spiral. Such a story did not look ridiculous last year as oil was heading toward $150. Now, however, it is a lot harder to tell. Too many “ifs” and “maybes.” A story that hangs together much better after a six-pack than my recent snack of sugar and caffeine.

Bottom line: I reiterate my concerns that the media and market participants are using the term “quantitative easing” too loosely. I understand that this complaint falls on largely deaf ears. If Bernanke is using quantitative easing to boost inflation expectations, then I think we need to seriously address the likely ineffectiveness of any such policy when Fed officials repeatedly promise to shrink the balance sheet in the future. In other words, they are explicitly committing to a temporary increase in the money supply. There is no reason to believe this will meaningfully impact inflation expectations. Such expectations, however, could be generated via a policy error. The error the Fed fears the most is they lose independence, the increase in money supply becomes permanent, and that political pressures force sustained increases in the money supply. Consequently, look for officials to consistently repeat their intentions to remain independent.

2 Responses to "Johnson and Kwak vs. Bernanke"

Anonymous April 5, 2009 at 1:30 am

There are many scenarios. Inflation does not look like a certainty just yet. Consider how similar the US political-economy looks to the Japanese-dynamic:Since the risk of yen appreciation keeps Japanese household income in Japan and since other investments (equities, commodities, real estate) do poorly in deflationary low growth environments, it makes sense that household savings would go into bonds. Since corporate bonds have higher yields than government bonds (and the BOJ buys the bonds back from households whenever the risk of corporate insolvency arises), these are the ones that are chosen.It seems likely that Japanese corporations may have used the cash from their bond sales to restructure bank debt (which may have also prompted generous counter-offers from banks with no other loan opportunities…) so they could stay afloat.In essence then, deflation and low growth caused savers to finance excess fixed capital (that wouldn’t be written off by zombie banks) and the zombie corporations that managed it. Excess fixed capital and the zombie corporations that managed it in turn caused deflation and low growth.If inflation and nominal interest rates were actually 0%, this process could theoretically go on forever. It might look something like: the BOJ prints money to fund roads to nowhere – zombie corporations & banks effectively sterilize the added money supply – a deflationary crisis increases the buying power of hoarded cash (that accumulates in the banks that have bought loans cheaply) – the BOJ prints money to fund roads to nowhere… (Note the effect a little fiscal austerity would have had on this process…) In that 0% real interest rate limit, the Japanese savers aren’t just financing investment mistakes – they are effectively buying them and bailing out inefficient management for their mistakes indefinitely.With moral hazard left unchecked, the inefficient management might add more of the same type of capacity that caused the original excess supply problem at a later date (sometimes even in the face of low capacity utilization, high unemployment, &/or unresolved debt burdens in various economic sectors). This might possibly explain why depression economics is characterized by multiple-dip recessions in several cases. It’s the political-economy’s way of saying, “Find something that’s both novel and needed.”Freeing a political-economy from such “real liquidity-traps” is certainly not sufficient for growth by itself. That liberated capital must finance the efficient implementation of some technology into a sector where it is not already present. (Should a “monetary liquidity-trap” have formed in the process of cleaning up a “real liquidity trap,” it can always be broken at a later date with another jolt of stimulus.)There are certainly scenarios that could lead to inflation in the US, but the US political-economy isn’t looking like it has chosen that trajectory definitively just yet. It is interesting to note, for example, that a successful investment firm with ties to the Treasury has decided to offer retail banking. On the one hand, it may be a good time for a solvent insititution to attempt to get market share in retail banking. On the other hand, such a bank would not want to extend many long-term fixed-rate loans – at least not until it was certain that inflation was not going to occur.